Understanding Percentage Rent in Commercial Leases

Commercial leases for retail and restaurant tenants often require the tenant to pay percentage rent. Percentage rent is that sum a tenant will pay in addition to base (minimum) rent as a percentage of a portion of the tenant’s gross sales.

A landlord will want the tenant to pay percentage rent to insure it enjoys a share of the tenant’s strong sales. No doubt a tenant would prefer to minimize lease payments by not paying percentage rent, but for the most part it is the industry standard, and agreeing to do so can be valuable in negotiating base rent. A landlord may agree to lower base rent in return for the ability to participate in tenant’s future sales.

The payment of percentage rent is generally based on a breakpoint. Once a tenant’s gross sales exceed that breakpoint, it will pay a set percentage of the excess to the landlord. The breakpoint is an important issue and subject to a variety of different approaches.

Natural Breakpoint:

A common method for determining percentage rent is to use a natural breakpoint. A natural breakpoint is calculated by dividing the base rent by an agreed percentage. The percentage rent payable by a tenant will then be equal to this percentage multiplied by the amount by which gross sales exceeds the breakpoint.

Example: A landlord and tenant agree that the tenant will pay percentage rent equal to 5% over the natural breakpoint. If the annual base rent is $100,000, then the breakpoint would be equal to $100,000 ÷ 5%, which is $2,000,000. If the tenant’s gross sales for a year were equal to $2,500,000, then the tenant would pay $25,000 in percentage rent, which is calculated by multiplying 5% by the amount by which gross sales exceeds the breakpoint ($500,000 × 5% = $25,000).[1]

Artificial (Unnatural) Breakpoint:

Another common method for determining the breakpoint is to use an artificial or unnatural breakpoint. The amount of the artificial breakpoint is a matter of negotiation and may be determined by the bargaining power of the parties or specifics of the transaction. A landlord with more bargaining power may be able to negotiate a breakpoint below the natural breakpoint, while a tenant with more clout may be able to negotiate a higher breakpoint.

Example: A landlord and tenant agree that the tenant will pay percentage rent equal to 5% over a breakpoint of $1,700,000, even though the natural breakpoint is $1,500,000. If the tenant’s gross sales for a year were equal to $2,500,000, then the tenant would pay $40,000 in percentage rent, which is calculated by multiplying 5% by the amount by which gross sales exceeds the breakpoint ($800,000 × 5% = $40,000).

In addition to defining how to calculate percentage rent, a lease must adequately address many other related considerations, including:

Defining what items should be included in, or excluded from, the gross sales;

Setting forth requirements for reporting gross sales;

Determining the timing of percentage rent payments;

Dictating when the tenant must keep the premises open to the public; and

Establishing radius restrictions.

Other approaches for determining percentage rent include the following:

Increasing or decreasing the percentage rent rate even if base rent is fixed; and

Using different percentage rates for gross sales generated by different product lines.

While the concept of percentage rent seems fairly straight forward, the financial consequences of getting this concept wrong can defeat the landlord’s or tenant’s expectations. An experienced attorney can help both landlords and tenants analyze and address issues needed for clear and workable percentage rent provisions.

[1] One reason given to support the natural breakpoint is that a tenant should only pay percentage rent on sales that exceed the amount required to pay the base rent. In this example, 5% of $2,000,000 is $100,000. Accordingly, the percentage rent rate would apply only after this base rent breakpoint is achieved, i.e. a natural breakpoint.

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